Personal Investor: What investors should do when short sellers start circling

Dale Jackson, BNN Bloomberg

Personal Investor: When the shorts start circling

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It’s a stealth risk for any long investor but more so for those dabbling in speculative investments. At any given time short sellers could be betting the stock you want to go up, will go down.

That risk became reality this week for shareholders of one of Canada’s cannabis producers, Aphria Inc., when short sellers Quintessential Capital Management and Hindenburg Research published a report alleging (among other things) the company acquired foreign companies at "vastly inflated" prices.

The revelation sent Aphria’s stock plummeting about 40 per cent in two days as investors questioned the validity of the company’s reporting. Aphria called the allegations “false and defamatory” but by then even the believers were caught in the downdraft.

It’s not the first time short sellers have taken down a stock but when it comes to speculative stocks with rich valuations, they’re always circling, looking for something investors don’t see.

Short sellers are often portrayed as sharks, but in reality they do wonders to keep publicly-traded companies honest when it comes to financial reporting.

Here’s how short selling works: Short sellers don’t own shares in a company – they borrow them with the promise they will be returned in the future when the short seller assumes they can be purchased at a lower price.

The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold on the open market and the proceeds are credited to the short seller’s account. The short is "closed" when the short seller buys back the same number of shares and returns them to the broker.

In most cases short sellers can hold the short indefinitely, but the broker will charge interest in a margin account. However, short sellers can be forced to cover if the lender wants the stock they borrowed back or they can borrow more shares.

Unlike a long investor – whose biggest risk is that a stock goes to zero – a short seller takes a risk that a stock will go up instead of down, and there is no limit to how high a stock can go.